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Liability Under Securities Law

A U.S. district court ruled that an accounting firm was not liable
under federal securities laws for misrepresentation in a company's
financial statements. In 1993, Ernst & Young client Cygne Designs,
a clothing manufacturer, announced the acquisition of another clothing
manufacturer in exchange for Cygne stock. It publicly represented that
this acquisition would increase its earnings and profitability. The
goodwill from the acquisition, which closed in April 1994, was booked
at approximately $47 million.

Notwithstanding Cygne's favorable public representations regarding
the acquisition, the plaintiffs—Cygne investors—claimed that Cygne and
the firm had learned during a due diligence review (before the
acquisition) that the purchased company was experiencing problems, so
there was no reasonable basis to believe the purchase price or the
booked goodwill could be recovered. The plaintiffs asserted section
10(b) and rule 10b-5 (of the Securities Exchange Act of 1934) claims
against the firm based on Cygne's 1993 and 1994 financial statements.
The plaintiffs said that the firm had fraudulently issued
"clean" audit opinions on the statements despite its
knowledge of facts that revealed the falsity of the statements.

In response to the complaint, the firm filed a motion to dismiss
pursuant to rules 12(b)(6) and 9(b) of the 1934 Act. In support of its
rule 12(b)(6) motion, the firm successfully asserted that the general
allegations of GAAP and GAAS violations failed to satisfy the
scienter requirements of section 10(b) and rule 10b-5. (The
scienter requirements can be satisfied by demonstrating
specific facts: (1) showing a motive for committing fraud and clear
opportunity for doing so and (2) indicating conscious or reckless
behavior by the defendants.) District Court Judge Kram agreed with the
holding in SEC v. Price Waterhouse (797 F. Supp.
1217 [S.D.N.Y. 1992]) that the mere misapplication of accounting
principles by an independent auditor does not establish scienter
. A plaintiff must prove that the accounting practices were so
deficient that the audit amounted to "no audit at all" or
that the accountant's judgments were such that no reasonable
accountant would have made the same decisions if confronted with the
same facts. In Judge Kram's opinion, for the plaintiffs' claims of
purported GAAP and GAAS violations to be actionable, the plaintiffs
would have had to allege that the firm's alleged violations were the
result of intentional deceit or that they rose to the level of
recklessness.

The judge said the complaint also failed to comply with the pleading
requirements of rule 9(b). In his opinion, a plaintiff can satisfy the
Second Circuit's standard for alleging facts (see SEC v.
Price Waterhouse , above) that give rise to a strong
inference of fraudulent intent in two ways: (1) by alleging facts
demonstrating a motive for committing fraud and a clear opportunity to
do so or (2) by identifying circumstances indicating conscious or
reckless behavior by the defendant. The plaintiffs failed to satisfy
either element.

The judge said the complaint contained no allegations of motive and
no suggestion that the firm had received anything but its usual fees:
The mere receipt of compensation and the maintenance of a profitable
professional relationship did not constitute sufficient motive for
purposes of pleading scienter .

According to Judge Kram, a contrary finding would require the
assumption that the firm willingly condoned Cygne's fraud in order to
preserve its fee, at the risk of jeopardizing its reputation and
license and the possibility of huge damages. Because this conduct
would be economically irrational, the judge said he could not credit
these allegations, citing the case of Shields v.
Citytrust Bankeom, Inc ., (25 F3d 1124 [2d Cir. 1994]). In
so doing, he acknowledged that he was disagreeing with decisions
holding that the receipt of professional fees provided a sufficient
motive for the purpose of pleading scienter . (See In re
Leslie Fay Cos., Securities Litigation , 835 F. Supp. 167
[S.D.N.Y. 1993]).

Judge Kram also decided the plaintiffs had failed to allege facts
that constituted evidence of recklessness: When motive is not alleged
and the plaintiff relies entirely on allegations of recklessness in
alleging scienter , the evidence presented must be
proportionately greater than if motive is alleged. The claim that the
firm knew or recklessly disregarded adverse facts about the
acquisition was insufficient because the claim was based solely on the
firm's status as auditor and the plaintiffs offered no specific facts
about how or when the firm learned of—or recklessly disregarded—the
problems associated with the acquisition. For instance, the plaintiffs
never said what alleged information was revealed to the firm, in what
form the information was provided, at what point the firm became aware
of it and from whom the firm received this information. Thus, Judge
Kram concluded the claim was insufficient under the requirements of
rule 9(b) as well. ( Zucker v. Sasaki , CCH
Securities Law Reporter, ¶99,493, U.S. District Court for the Southern
District of New York, no. 95 Clv. 10517 [SWK])

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